How can the Kremlin institute effective economic reforms?

A strong new commitment to the rule of law, both domestically and internationally, is fundamental if Russia genuinely wants to halt economic decline and achieve prosperity in the future, argues Andrey Movchan from the Carnegie Moscow Center.

"Once one sector collapses, it could lead to a domino effect, leaving 5 to 10 million people unemployed. Neither the government nor the private sector has anything to offer these laid-off people if this contraction takes place." Photo: RIA Novosti

This is the abridged version of the analysis that first appeared at the website of Carnegie Moscow Center. The article has been edited and condensed by Russia Direct’s editorial team. Read the original article here.

Russia faces bleak economic prospects for the next few years. It may be a case of managed decline in which the government appeases social and political demands by tapping the big reserves it accumulated during the boom years with oil and gas exports. But there is also a smaller possibility of a more serious economic breakdown or collapse. A proper analysis requires consideration of a number of key and often overlooked features of Russia’s post-Soviet economy.

Misleading indicators

Any quantitative analysis of the state of Russia’s economy is limited by the unreliability of measurement methods and the accuracy of available data. Pre-1991 economic indicators are hardly any use as statistical methods employed in that era were completely different from modern ones. They measured an artificially valued currency and operated within a price-controlled economy. Statistics did improve after 1991, but there are still serious question marks about their validity.

An additional complication is the problem of how much Russia’s large shadow economy contributes to its gross domestic product (GDP). Shadow business comprised 10 percent of the Russian economy in 2013-2014 — a significant drop from the 1990s, when, according to some estimates, unofficial businesses actually outnumbered officially registered ones. It is far from clear, however, how official statistics measure numbers for the shadow sector.

Secrecy is another factor. It is difficult to give accurate figures on Russia’s budget spending when more than 30 percent of it is classified as secret. It is generally believed that the classified items in the budget are used to finance the military-industrial complex and security agencies, but there is indirect evidence suggesting that these funds have many other uses as well. They may range from financing the “friends of Russia” abroad to closing gaps in the balances of state controlled companies and allowing top officials to make personal purchases.

Russia’s economy after 2000

In the last fifteen to sixteen years, the Russian economy has undergone a classic resource cycle and Dutch disease caused by a big influx of oil and gas revenues.

Russia’s political system, lacking strong checks and balances, exacerbated these economic distortions. By the time Russian President Vladimir Putin took power in 2000, the majority of key assets were owned either by the state or by a small group of private individuals, who had obtained these assets from the state in return for political loyalty. After the constitutional crisis and violence of 1993, the president and Kremlin administration had appropriated almost all power to themselves. Parliament played an advisory role at best, while parliamentary parties swore loyalty to the president in exchange for economic rewards.

At the same time, the ruling regime aimed and succeeded at gaining back full control of the oil exploration and trading business, after it arrested the rebellious oligarch Mikhail Khodorkovsky in 2003, nationalized his Yukos oil company, and ensured all other oligarchs got the message and would obey. The regime gradually consolidated its indirect control over the hydrocarbon industry and banking, and, by extension, over the country’s entire economic sphere.

By 2008, 65 to 70 percent of the Russian budget effectively either directly or indirectly consisted of hydrocarbon export revenues. The massive influx of petrodollars into the Russian economy also led to a strong overvaluation of the ruble. In 2006–2007, its real exchange rate exceeded the inflation-adjusted rate by over 35 percent.

A Ministry of Finance report suggests that foreign trade accounted for 38 percent of budget revenues in 2014.Only up to 8 percent of this came from non-natural-resource exports, with hydrocarbon exports accounting directly for 35.4 percent of the federal budget. When one takes into account natural resource-related taxes, fees and payments (20 percent), as well as value-added tax (VAT) paid on imported goods — which are primarily bought with petrodollars (17 percent) and custom duties and excises on imports (13 percent) — the overall contribution of oil and gas in the federal budget appears to be much higher and comprises at least 83.4 percent of the total.

That is not even the end of it. Businesses involved in oil-and-gas production pay taxes on their revenues, and so do workers employed in this sector. Forty percent of individual income taxes are collected from federal and public-sector employees. So it’s not surprising that oil prices and federal budget revenues correlate with over 98 percent accuracy. Nowadays, as Russia faces a decline in oil prices, it has an undiversified and quasi-monopolized economy that lacks the capability and resources for growth.

The impact of external factors

Since the Ukraine crisis blew up in 2014, Russia has been subject to economic sanctions from the United States and a few other countries, as well as the EU. It has responded by launching counter-sanctions against the same countries. Although this is a major political topic, its significance for the Russian economy is almost certainly exaggerated — at least in the short term.

Western sanctions effectively prohibit a limited number of Russian commercial organizations from borrowing in international markets. They also prohibit Russian businesses from owning assets in several countries and block a small group of Russians to enter them. Finally, the sanctions forbid the transfer to Russia of a limited list of technologies, mainly connected with mining and the military.

Restrictions on borrowing can only have a limited impact on a country that has been consistently reducing its external debt for several years now — and besides, the list of entities affected by the ban is quite short. If financial sanctions are expanded to include more borrowers (or the state itself), they will have a devastating effect on the Russian economy in three to five years’ time, when the country’s capital reserves are exhausted and it is forced to borrow large sums. But for now, sanctions are limited in scope. Meanwhile, restrictions on technology transfers will have a negative impact on the Russian economy in the long run.

Perhaps the greatest harm being inflicted on the Russian economy by the political row with the West comes from Russia’s unpredictable, inconsistent, and hostile behavior toward international economic institutions. As a result of efficient lobbying efforts from domestic companies, there have been several attempts to make the country autonomous in spheres such as telecommunications, payment and transportation systems, IT, and navigation. Domestically produced alternatives are generally inferior and costly for the budget and end-use customers. This policy did not result in making a few businessmen close to the Kremlin much richer. Its end result is that Russia’s national security is threatened not from abroad but from the home front.

In 2017, the trend continues

The year 2016 surprised even seasoned experts on the Russian economy. Sharp variations in the oil price from below $30 a barrel to $50 a barrel did not greatly alter the country’s economic indicators, except for the ruble exchange rate. Despite consistent declines in both oil and non-oil exports, the foreign trade balance remained on the plus side, and the year-end balance is expected to be over $80 billion. In 2016, the economy continued a slow, gradual contraction, but without any major upheavals.

Not much is likely to change for the Russian economy in 2017. The commodities market promises to be more stable. Conservative forecasts predict oil price fluctuations between $40 and $60 a barrel, which will ensure sufficient stability for the budget. One of the major risks in the coming year will be the return of pent-up demand to consumer and industrial markets. In 2014 and 2015, a combination of negative expectations and declining personal incomes made consumers substantially reduce their purchases of durable goods.

One can expect a gradual and gentle decline in all Russia’s economic indicators in 2017. Inflation will probably be higher than the government projection of 4 percent, but it is not likely to exceed 6–7 percent due to the depressed state of the economy. The strength of its reserves and relatively high oil prices will allow the Russian government to maintain a strict monetary policy. As before, the dollar exchange rate will track oil prices and inflation.

But GDP will continue to stagnate or even fall because of the absence of growth drivers and declining entrepreneurial activity. Modest budget subsidies cannot really replace private-sector investments, which are likely to decline 10–20 percent more. Long-term investment, including capital construction, is headed for a steeper decline. According to some estimates, capital and especially housing construction may decrease in 2017 by as much as 50 percent, compared to 2014.

As in 2016, Russia’s budget deficit will be manageable. The government believes that it will not exceed 3 percent of GDP thanks to “additional budget revenues,” mostly from privatization of the state companies. Most likely, the deficit will be around 4 percent of GDP ($50 billion), and this will be covered by reserves. However, the government has discussed its plans to start active domestic borrowing, so we will see how the market assesses debt risks and costs in 2017.

Russia’s budget — resilient, but for how long?

The Russian economy is contracting and gradually losing its global competitive edge, even in the sectors in which it can still create competitive products. Lately it has developed a serious monetary imbalance. The country has run budget deficits for the past three years. Yet the problems of the state budget, which previously derived almost all its revenues from natural resources and was over-inflated during the years of high oil prices, seem neither catastrophic not insoluble.

In the near term, the budget deficit can be covered by additional taxes on the oil-and-gas industry, as well as by using remaining government reserves, state borrowing of various forms, and cutting budget spending in a number of areas in defiance of lobbyists, including the untouchable defense and security sectors.

The state will be able to maintain an initial budget deficit of approximately 3 trillion rubles ($50 billion, 4 percent of GDP per year) for three to four years. Domestic debt increases at the rate of 1.5–2 trillion rubles per year will not burden the budget with excessive interest charges for at least five to six years. The rest of the deficit can be covered by the Reserve Fund and the liquid part of the National Wealth Fund. These funds will last for less than three years, and from about 2020 the government will have to replenish them through a combination of budget cuts, tax hikes, and currency emission by the Central Bank.

It is hard to forecast how long the current budget construction will endure. If oil prices start rising again, every $10 price increase will add $20–$40 billion to the budget. In other words, oil prices of $65–$70 a barrel will virtually eliminate the budget deficit for the time being. Likewise, an oil price of $30–$35 a barrel would seriously exacerbate the deficit problem and could trigger a serious budget crisis as early as 2019–2020.

In any event, Russia will have to completely review its current model of budget spending. This can basically be done in two ways. The government could somewhat reduce social welfare spending, drastically reduce defense spending, and attempt to return to its former status of being a client on the global stage by opening its markets again, asking for loans, and asking for International Monetary Fund assistance. Alternatively, it could opt to drastically reduce social spending, maintain the current level of defense and security spending, and drift toward complete economic and political isolation.

At the moment, the Kremlin looks much more likely to adopt the second option which will allow it to keep political control for some time. However, the government’s draft budget in 2016 for the next three years did not make any attempt to lower social spending.That is a good sign, showing that the Kremlin is afraid of a public reaction and maybe will force major budget consumers in the defense, industrial, and bureaucratic lobbies to agree on a reasonable reduction in their shares of the pie.

Economic black swans

Although most indicators promise a soft landing for the Russian economy and several calm years ahead, one cannot rule out some extreme scenarios or black swan events, which could potentially lead to economic breakdown in Russia, the loss of control over the ruble, a devastating decline in budget revenues, big shortages of goods, and destitution for a large percentage of Russia’s population.

This economic shock could in turn trigger new disasters: a sharp increase in crime rates, greater autonomy for most donor and dependent regions (the former will no longer want to share their wealth, while the latter will look for ways to survive without federal government subsidies), active and perhaps even successful attempts by some regions to secede from Russia, local armed conflicts (primarily in the North Caucasus), and perhaps attempted coup d’états.

These events will be followed by a long period of political instability and possibly even the breakup of the country, as happened with the Soviet Union but with even greater bloodshed. No one event could trigger this catastrophic chain of events in the next few years. But, a combination of two to three factors could indeed set them off.

First, it could be a major banking crisis that is not efficiently neutralized by government subsidies and capital injections.

Second, economic havoc could be caused by the disruptions at a large number of infrastructure facilities due to amortization or interruptions in energy supplies. This scenario looks more plausible if authorities move forward with reductions in overall budget allocations and suspend investment in modern technology.

Third, a sharp decline in hydrocarbon production, combined with continued low global energy prices, also poses a threat. It is even possible that outputs will start falling significantly in three to four years, and Russia’s lack of advanced exploration technology (partly due to sanctions) will keep them low. Venezuela is a good example here. The country has lost two-thirds of its possible output and is already buying oil from overseas. The unlikely but possible scenario of an EU embargo against Russian oil-and-gas exports could have a similar effect.

Fourth, crises in major industries could also be destabilizing. As purchasing power in Russia falls over the next few years, the demand for goods and services — particularly durable ones — will fall significantly. As a result, an entire range of industries will be under threat, from the personal care sector to the construction industry. At a worst-case scenario, one can assume that it will contract sharply, causing 1 million people to lose their jobs. Banking, shipping, tourism, hotels and restaurants, and import retail are also vulnerable. Crucially, once one sector collapses, it could lead to a domino effect, leaving 5 to 10 million people unemployed. Neither the government nor the private sector has anything to offer these laid-off people if this contraction takes place.

Fifth, internal elite conflicts are unlikely but possible. They are unlikely because the interests of various groups are well defined and all the key players understand that keeping the peace is in everyone’s best interests. Even if elite infighting does not erupt into all-out war, it might have a significant destabilizing effect on the economy. Stable and well-organized elites could face the same situation if a key person who balances differing interests becomes dysfunctional or is eliminated. Only one person now plays this role in Russia, and while the chances of him suddenly becoming dysfunctional are low, the possibility exists.

Finally, Russia lacks strong governmental institutions, political competition, and a system of critical decision analysis. Propaganda distorts public opinion and distracts it with false agendas. In this context, there is a very high risk of very costly, irreversible, and irrational decisions being made that will drastically change the situation. It is hard to predict what kind of decision this would be. The government could decide to impose crippling tax burdens on businesses, which would result in a catastrophic decline in business activity. It could escalate or initiate new military or hybrid operations that undermine the economy or draw a new round of much tougher sanctions. It could introduce new harsh price, currency, capital controls.

How to institute effective reforms

The Russian economy currently suffers from two fundamental problems: excessive regulation and high risks that discourage doing business. Present-day Russia with declining demand, a shrinking workforce, and a lack of resources does not have sectors where excessive profits can be made—with the exception of criminal activities, corruption schemes, and state-related and/or state-subsidized businesses (which are often a combination of the former two).

Russia is tightly insulated from international cooperation and has a fairly small population (2 percent of the world’s) for such an insulated market, which is not big enough to compete in prices and quality on the global market. Russia is a country of quasi-monopolist conglomerates that provide essential services like energy and transportation to businesses at inflated prices. Russia is greatly dependent on imports, meaning that its companies buy supplies at high prices and are taxed at high rates.

That means that the only way to increase the country’s economic potential under these circumstances is to reduce risks. Certain basic risks have to be addressed for Russia to get back on the path to prosperity. The first risk relates to property rights, which are little respected in today’s Russia (even the mayor of Moscow condescendingly refers to certificates of ownership as “fraudulent papers”). There is also a high risk factor and uncertainty in the application of local legislation, both in disputes between businesses and the state and in disagreements between businesses themselves.

However, Russia could minimize risks in the pursuit of economic growth. It needs a comprehensive change of legislation directed at protecting investors’ and entrepreneurs’ rights. It has to guarantee the primacy of international law and courts, presumption of innocence of businessmen in cases where the government plays a plaintiff role. All these changes would lower the risks for investors and entrepreneurs and transform the country’s current feudal and corrupt legal system into one based on the rule of law.

Finally, a very important way of reducing risk is to strengthen the body of legislation that protects investors and entrepreneurs from adverse legislative changes and government acts, both those that conform to government legislation and illegal acts. This legislative ambiguity has caused business losses or missed opportunities, in cases when businesses were started or managed with a reasonable belief that things would be otherwise. This has an international dimension: it is important that the Russian government in no way impedes class-action lawsuits and other cases in international courts.

A strong new commitment to the rule of law, both domestically and internationally, is fundamental if Russia genuinely wants to halt economic decline and achieve prosperity in the future.